Drug Prices: a Solution

T here have been a lot of complaints about prescription drug prices lately; critics-among them high-profile candidates for public officeseem to think they are too high, and they point to drug-company profits as proof. At least some of these critics are openly looking for ways to impose price controls on prescription drugs. For example, on June 27, the AFL-CIO and a number of liberal advocacy groups gathered both in Washington and at several state houses around the country in a show of support for price-control legislation that has already been passed in Maine. Participants claimed to "recognize that prescription drug prices are spiraling out of control," and they intended to do something about it.

Of course, some of the newer prescription drugs are expensive, but there is a reason for that: It's called research and development. Pharmaceutical companies spent about $21 billion in 1999 developing and testing new drugs, and they have to recover those costs if they intend to continue that R&D.

It is also true that most pharmaceutical companies are profitable-with profits averaging about 18% of revenues in 1999. But that profit range is in line with other New Economy industries. For example, the computer software industry's profits averaged about 15%-and that included a few companies that did very poorly, pulling the average down.

Why would the pharmaceutical industry be considered a New Economy industry, considering it has been around a long time? Because drug companies invest heavily in high-technology intellectual property, having evolved into what we might call the "pharmatech" industry. As in the software industry, once the pharmaceutical product has been developed, the cost of reproducing it for consumers is negligible.

Treasury Secretary Lawrence Summers understands the principle well. In a May speech delivered in San Francisco titled "The New Wealth of Nations," Summers noted that in an informationbased economy, "the only incentive to produce anything is possession of temporary monopoly power-because without that power the price will be bid down to the marginal cost, and the high initial fixed costs cannot be recouped."

However, many lawmakers, some of them perhaps motivated more by attracting votes than establishing good public policy, intend to ignore Summers' analysis and move ahead with price controls. If they really want to control prescription drug prices, there is a better way to do it than by government fiat. It's called competition. In fact, that remedy may already be taking effect, and politicians should leave their hands off long enough for the market to work.

In a real market:

Companies create products they think will sell and then advertise in order to attract customers and maximize sales. That is what is beginning to happen in the pharmaceutical industry, as companies increasingly target consumers with their drug ads.

When a company is successful in attracting customers to its new products, profits may go up-which in turn attracts competitors to enter the market with the same or a similar product. When a company has the corner on a market, economists call it "monopoly profits." If competitors are prohibited by copyright or patent law from duplicating the product, they often try to come up with knockoffs or substitutes in the hope of attracting some of those consumer dollars.

Once competition sets in, companies begin to look for ways to maintain a certain share of the market. They may cut prices, advertise more or engage in other activities intended to attract more consumers.

If competitors are successful, the sales and profits of the first company will begin to decline, which may also reduce profits.

Economists know this pattern well and usually argue that it is best to let the process work. The lure of profits is what drives a company to come up with a new product in the first place, and it's the lure of profits that drives other companies to imitate a product when one company is successful. Thus, a new idea or product may make lots of money for a little while, but competition eventually reverses the process.

But can prescription drugs, many of them protected by patent, act like a market? Yes, competition can even force monopoly prices somewhat lower when there are numerous similar competing products. The explosion in pharmaceutical R&D has led different companies to create different patentable products for the same condition. For example, there are three "superaspirins" -Arthrotec, Vioxx and Celebrex-currently on the market for treating chronic pain such as that caused by arthritis. All three cost about the same, around $75-$80 a month. In an increasingly competitive market, you would expect one company, trying to gain market share, to lower its price to attract more customers.

The drug industry is already competitive. No drug company has more than 8% of the market. True, the prescriptiondrug market doesn't work exactly like a normal market in that a physician who doesn't have to pay for the drug fills out the prescription for a patient who does. But many physicians are sensitive to costs and want to prescribe the product with the best effect at the lowest price, and they are increasingly willing to make cost considerations a factor.

So if Congress is concerned about drug-company prices and profits, the proper response is to adopt policies that encourage competition, not restrict it as price controls would. In fact, Congress has already adopted some policies that have enhanced competition among drug companies, which explains their heightened visibility. In just 10 years direct-to-consumer advertising has grown from $55 million in 1991 to an estimated $1.8 billion this year. However, most of that growth came after 1997, when the Food and Drug Administration loosened some of the restrictions on such ads. As a result, the pharmaceutical market is beginning to look more like a real market.

If Congress is serious about controlling prices, it should be removing restrictions from the pharmaceutical industry, as it did in 1997, to allow more competition. Given more competition, prices would likely fall, but they would do so voluntarily-that is, the pharmaceutical manufacturers themselves would look for ways to hold down costs as they tried to maintain market share. There would be increasing pressure to develop more new drugs and keep prices down in order to stay competitive.

There are two ways we can hold down drug prices: externally or internally. When the government imposes price controls externally, it leads to reduced research and development, shortages and rationing. When drug companies lower their prices in order to compete, they also look for new ways to get new products on the market faster. Competition in a market relatively free of regulations, not price controls, is the best way to keep drug prices low. And if drug prices were lower, no one really would care what the companies' profits are.

MERRILL MATTHEWS JR . is a visiting scholar with the Institute for Policy Innovation and policy director for the American Conservative Network, a project of the American Conservative Union.

This copy is for your personal, non-commercial use only. Distribution and use of this material are governed by our Subscriber Agreement and by copyright law. For non-personal use or to order multiple copies, please contact Dow Jones Reprints at 1-800-843-0008 or visit www.djreprints.com.